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MGFC30: Introduction to Derivative Markets

Fall 2022

What are Foreign Exchange Futures?

The Foreign Exchange(FX) market is the largest capital market in the world,traded around the clock, worldwide, everyday, with all  FX transactions globally averaging close to $5.3 trillion dollars per day.To put this in perspective, the most quoted market,U.S. stocks,trade close to $200 billion per day.

Foreign Exchange Futures contracts operate similarly to regular futures contracts as the contract is purchased to buy or sell a specific amount of an asset at a particular price on a predetermined date. However FX futures unlike regular futures are not traded on a centralized exchange. Instead deal flow is available through many different exchanges globally,with the vast majority of FX futures traded through the CME exchange.

What Catalysts affect Foreign Exchange Futures?

Since FX futures are based on the exchange of one currency for another,catalysts that affect currency prices directly affect FX future contracts.This factors include: 

  • Inflation Rates
  • Interest Rates
  • Country’s Current Account / Balance of Payments
  • Government Debt
  • Terms of Trade
  • Political Stability & Performance
  • Currency speculation

What are common Index futures trading strategies?

A hedging strategy involves the use of FX futures to reduce risk by insulating themselves against any future price movements.An example of such risks are currency fluctuations from foreign sales revenue.Therefore an overseas business could purchase a futures contract in the amount of its projected net sales to eliminate currency fluctuations from its stores located abroad.

Furthermore, the cash behind a FX futures contract is calculated daily, and the buyer and seller are held liable for daily cash settlements.Therefore when using FX futures for hedging,you have the ability to re-evaluate your position as often as you like. 

A speculating strategy involves investors trading FX futures with higher risk with hopes for a higher than average return or in other words to make a profit. strategies employed for speculating can be based on a technical chart analysis or most advanced strategies such as arbitrage. It is important to realize that speculating FX futures it is vital to have market expertise they aim to predict price changes in more volatile sections of the markets in pursuit for larger profits.

An example in the past.

For our first example let's look at how federal monetary policy affect an FX future. In this case we will be looking at canadian dollar futures or the CDU7 contract in specific.

The Bank of Canada on the 12th of july raised interest rates by 25 basis points to 0.75%. While any change in a country's monetary policy can cause FX futures values to fluctuate, an interest rate hike for the first time in 7 years is sure to cause an uproar.

As we can see from the graph the CDU7 contract price went up by 1.49% on the day that the rate hike was announced. Therefore if you were trading CDU7 contracts at the time, you could either predict a hike, drop or unchanged interest rates before the rate hike was announced.

Let's assume you predicted accurately and expected a`hike in interest rates.You would subsequently then also expect a  spike in the future contract prices after the announcement. Since you expect the contract price to rise, you would purchase CDU7 futures contract and take a long position in anticipation of that potential rise.

However it is also important to understand when to flatten your position when trading futures contracts.

As we can see from the graph by the very next day on 13th of july the CDU7 contract price is already down 0.45%.While you would still make gains whether you decided to flatten your position on the 12th or 13th of July, you would lose 0.45% just by deciding to flatten your contract a day later. Moreover while 0.45% change might not seem significant on the surface, the fact that a single CDU7 contract itself costs CAD 10,000 means that even smaller price fluctuations can have a significant monetary impact.

What is  even more interesting to see is that just 4 days later on 17th July, CDU7 contract price actually went up by 1.03% from the 13th.

So while it might have been beneficial pursue a long position on the contract for an extended period of time,it is advisable to only do so when additional or a change in current catalysts have been identified.

The reason for this is that the FX futures market is highly volatile and so it is even more important to only take a minimum calculated risk by creating and following a focused investment strategy.